At the end of the first quarter, the UK became the fourth country behind Israel, the UAE and Chile to have administered more than 50 vaccination doses per 100 people in its population. As this remarkable progress continues, we hope that the COVID-19 pandemic will no longer be front and centre of our market commentary.
In reflecting upon the last year, it has been one of many challenges, sadness and difficulties but perhaps it is also right, to look forward and concentrate on the positive outcomes and the opportunities that have been created. It appears that in 2021, financial markets certainly began the process of the latter and the dominant themes in the quarter were of relief, optimism and hope often described by commentators as a backdrop of reflation.
This cheerful outlook saw market participants argue that higher government spending was about to be complemented by consumers who have built up considerable savings during the pandemic and provide a demand-led shot in the arm to dormant economies the world over. The result was a repricing in inflation expectations and thus a repricing in the path of future interest rates, as indicated by the often quoted 10-year yield on US Government bonds rising from 0.9% at the start of the quarter to around 1.75% at the end.
What is good news for the economy is not necessarily good news for all financial assets though and higher interest rate expectations saw bond prices fall and a rotation in market leadership. The beneficiaries in the first quarter have been areas of the market often described as ‘value’ – these are typically more cyclical economically sensitive and less expensive businesses.
But whilst market participants have begun to price in a backdrop of reflation, which would cause higher interest rates, the Fed remains steadfast in its prediction that any rise in inflation may be transitory and, therefore, not require any change in interest rate policy.
In a speech given at the end of the quarter Jay Powell, Chair of the Federal Reserve, said that he did not expect a burst of economic activity this year to ‘produce substantially higher prices or that the effects will be persistent’. If he is correct, beneficiaries would much more likely be areas of the stock market often described as ‘growth’ – these are mostly larger, often defensive and more expensive businesses.
The question for investors at this point is whether continued optimism and the economy springing to life causes the Federal Reserve to catch up with the market. Or, whether a pause for breath and a cautious consumer causes the market to re-align itself with the Federal Reserve.
Nobel Prize winning economist, Harry Markowitz said as part of his work on modern portfolio theory that ‘diversification is the only free lunch in investing’. In the face of such uncertainty, investors might do well to take heed and enjoy a free lunch at this time.